For registered reps, annuities, one of the most lucrative and complex items in an advisor's repertoire, can appear to be a cure-all for clients. Clients seem to love them, because of the guaranteed income — even if they don't understand them.
Many an advisor has built a business around annuities, particularly variable annuities, which pay out generous commissions to brokers. These make up most of annuity sales. Just ask Tom Gau, of Oregon Pacific Financial Advisors in Ashland, Ore. Gau, a financial advisor and a member of our Top Advisor list (see page 87), runs the “Million Dollar Producer Two-Day Financial Advisor Boot Camp” and, as a result, has met hundreds of producers over the years. Gau says he is amazed by the number of reps whose businesses are completely dominated by annuities — sometimes up to 90 percent. And, worse, their ranks seem to be growing. “If a client wants an IRA, or wants to save for college, no matter what, these guys will recommend a VA. It's like going to the doctor and no matter what you have, he gives you the same prescription.”
This has attracted the attention of regulators and consumer watchdogs, who complain that annuities are being sold to people for unfairly large commissions by salesmen who don't really understand them. Indeed, annuities are so popular — and so misrepresented by producers — that several states are introducing laws to increase scrutiny of annuity sales and, in at least one case, limit who can buy them. The SEC is joining in. It found that supervision of annuity sales, plain-English disclosure and training of reps are inadequate industrywide. As a result, there are too many inappropriate annuity transactions, according to the SEC.
Annual annuity sales more than doubled over the past 10 years, with about $1.7 trillion in combined net assets invested in them. Variable annuities represent about $1 trillion, a roughly 7 percent increase from a year ago, according to the National Association for Variable Annuities. VA sales commissions are among the highest in the industry (5 percent to 6 percent) — something some annuity providers are shameless about promoting. One advisor recalls seeing a recent VA advertisement in an industry trade magazine “in which the commission rate was in 18-point type, and whatever benefits to the client were in 10-point type. The vendor was sending a pretty clear message.”
The relatively big payday is coupled with the fact that the sales pitch is easy to make. In variable annuities, client funds are placed into underlying mutual funds, ranging from aggressive growth products to capital preservation funds. The value is based on the underlying funds. (Fixed annuities promise to payout a fixed amount every year.) Income is tax-deferred. Protection clauses in VAs are alluring: Terms like “guaranteed minimum death benefit,” which locks in an amount clients can leave beneficiaries, even if the overall account's value has declined at the client's death, or “guaranteed minimum income benefits,” which secure clients a basic annuity payment regardless of market conditions, appeal to investors concerned about future market performance, especially those nearing or past retirement.
The problem is that many VAs are stuffed to the gills with additional costs, ranging from a percentage of net assets charges (which sometimes are deducted daily) to transaction fees, which are levied whenever a client shifts money between accounts. (The charges tack on 50 to 100 bps in additional fees compared with an average mutual fund, advisors say.) Mortality and expense (M&E) risk charges alone average 1.35 percent of invested assets each year, which means a $1 million account could have annual M&E fees in the $15,000 range. And that's not even taking into account the additional layer of management fees of the various funds VAs invest in. Further, most VAs have no breakpoints. No matter how large an investment the client makes, his fees will not be reduced.
“Inherent in any insurance product are more layers of fees for people to pay — it's one of the obstacles. Fund performance has to be so much better from the get-go to compensate,” says David Bendix, with Bendix Financial Group in Garden City, N.Y.
Are the benefits worth it? Some reps who use VAs sparingly believe there is a misinterpretation of what the product's real function is.
“The reason VA expenses are high is that they are not primarily investment products — they are risk management products,” says John Olsen, of Olsen Financial Group in Kirkwood, Mo. “Mortality charges are basically insurance charges. If a person doesn't want these items, it's nuts for them to be paying for them.”
Yet at the same time there is a general misperception that extra VA charges are all overhead charges, Olsen adds. In reality, many are needed for the insurer to fund its various guarantees. “While I still believe fees are too high, there are some counter factors. Some insurers were hit hard during the last stock market dip, and the reality is that there is actually a general concern that these companies might not be charging enough to cover these benefits.”
That said, some broker/dealers have had enough with expensive VAs and are asking VA providers to either reduce their fee structures or face being removed from the dealer platform.
Some insurance companies appear to be getting the message. Just recently, Jefferson National Life Insurance rolled out a product, Monument Advisor, that is stripped down — shorn of the expensive bells and whistles advisors have come to associate with VAs. Monument Advisor's total expenses are a $20 charge a month, $240 for a year. There are no product withdrawal charges, no contract maintenance charges, no administrative fees. (Monument Advisor still passes along the investment charges of its underlying funds, which range from 0.26% to 2.54%.)
In July, The Phoenix Companies rolled out a new VA with a more flexible cost structure that will enable reps to tailor-make a particular VA for clients. “It has not been unusual to have to come out with five different annuities,” each with its own benefits, cost structures and quirks, says Mark Tully at Phoenix. “We felt that it would be better to have one product with a lot of options, so advisors would only have to learn the product once.”
Expensive, But Good for Some Clients
Most advisors believe VAs have a place in client portfolios, especially for clients with conservative investment tastes or those whose primary concern is to have a guaranteed source of income to supplement Social Security during retirement.
On the surface it would seem to be financially unsound to invest in VAs when you could invest in the same products directly, either through stock or mutual funds. But it is the guarantee that makes the difference.
“If I can guarantee at the end of 10 years that you will have made 5 percent a year, no matter what happens in the market, I would have to have a much larger waiting room,” Bruce Levy, of Emerald Asset Advisors in Weston, Fla., says. “The only place on earth where I can be in the markets, in stocks, in bonds and, still have a guaranteed return on my money, is in a variable annuity.”
Levy says guaranteed death benefits are a key selling point to investors, particularly those close to or in retirement and who are worried about their heirs losing out if the markets crater when the annuity must be distributed. Say a client puts $100,000 into a mutual fund, which then falls to $90,000 at his time of death — his heirs will only receive the latter amount. But in a VA with a guaranteed death benefit, the client's heirs would receive not only the $100,000 back regardless of market conditions but also could receive additional accrued interest.
One typical scenario for Levy is that when managing a $1 million portfolio for a relatively conservative investor, he may put $100,000 or so of assets into a protected annuity. “We can take a little more chances on the investment side inside the annuity. Why? Because we know we have a downside protection.”
Guaranteed minimums also appeal to clients facing retirement. A client in the 65-to-70 age bracket with $300,000 saved still has the potential to live 30 more years, so that nest egg will not last very long. VAs however, can guarantee clients in this predicament a basic monthly or semiannual payment, “which assures them that no matter what, their food, shelter and clothing needs will be covered,” says Carly Maher, VA manager with the Commonwealth Financial Network in Waltham, Mass. “If it comes down to 30 or 40 basis points extra, they feel it's worth it.”
On the flip side, some advisors feel that despite these benefits, VAs can be abused, particularly when they are sold to consumers without disclosing factors like surrender charges, or the lack of tax protection many VAs have. Such abuses are driving investigations into the VA industry, mainly at the state level, including California, Connecticut and Massachusetts. The NASD has also sounded alarms about the products, proposing regulations to require plain-English disclosure documents and suitability checks by supervisors before a contract is issued.
One big disclosure problem: Many clients aren't made to understand that VA withdrawals are not taxed at the capital gains rate, as in mutual funds, but at a regular income rate, which can be far higher in many instances.
Also, the consequences of being locked in long-term in a VA is sometimes not spelled out. One worst-case scenario is that an elderly client will make his heirs the owners of the annuity. However, the client may not be aware that the terms of the annuity are still in force upon the client's death. Thus if a 25-year old is named as the recipient, he will be unable to access the annuity until the surrender period is over, sometimes 20 years after purchase, and if he does withdraw he faces an enormous penalty.
It is this type of story, rare or not, that has piqued the attention of ambitious state attorneys general, leading some reps to believe that VAs will be the next big financial investigation. What is worse is that the complexity of the market is sometimes ignored by prosecutors. One rep attended a recent conference in which attorneys were attacking VAs and came away thinking that few speakers had a real grasp on the issues. “One attorney who testified was just dead wrong. It was just someone who was irate about these terrible products we're selling to seniors and wasn't really interested in learning about them.”
Reps fear that an overreaction could take place at the state and federal level — for example, Connecticut regulators had been bandying a potential reform that would have prohibited sales of VAs to anyone over 65. There also has been a rumor that the NASD could push through new mandates of its own, such as imposing breakpoints on VAs. “VAs are going to be better than Enron as targets,” Olsen says.